The returns from high-yield bonds are positively correlated with those from investment-grade corporate bonds. No surprise there, one might think. But what is less well known is that the returns from high-yield bonds have a stronger correlation with equity returns.
Over the 10 years to 31 March 2016, European high-yield bonds recorded a 55 per cent correlation with investment-grade bonds, but a 73 per cent correlation with European equities.
Long-term asset class return correlations
|Eur HY||USF HY||IG Corp||10Y Bund||Euro Stoxx||EMBI Global|
Source: Merrill Lynch, Iboxx, JP Morgan, RIMES 31 Mar 2016. Correlations of monthly returns since 2006
Of course, past performance is no guide to the future. But historically, the correlation has been strong because the price of a high-yield bond has different drivers than a straightforward investment-grade bond. It is not an equity – but at the same time, it is not a conventional bond.
When you invest in equities, you receive dividend income, together with the potential for capital gains if earnings are on an upward trajectory. But equities can be volatile; because there is no maturity date, they are characterised by almost infinite duration.
In contrast, with a high-yield bond, if you buy a five-year bond with a 5 per cent coupon, you will collect the coupon (aka interest) each year.
Let us illustrate the difference with imaginary company XYZ plc. Its expected sales growth is 10 per cent a year. Accordingly, its shares will be valued with a super multiple. But if those earnings expectations are revised downwards, the fall in the share price can be precipitous. As soon as a company goes ex-growth, its share price may fall dramatically, because as soon as a company loses its growth-stock ‘halo’, equity markets will punish it severely.
Contrast that with the experience of the investor in XYZ’s high-yield bonds. All things being equal, if the balance sheet still works when revenues are growing at 2 per cent, high-yield investors do not really care whether earnings growth is 5 per cent or 10 per cent. As long as the cash flows are sufficient to pay the coupon, bondholders care to a lesser extent whether the growth rate is slowing. That is an equity story. The price of the bond might have been dented – but to nothing like the same extent as the company’s equity. As long as the balance sheet continues to work, by which we mean that the debt levels remain sustainable, high-yield investors are much more protected from the downside.
And do not forget – coupons on bonds are contractual; a dividend is not. Instead, a dividend represents a promise – best endeavours. Additionally, bonds rank higher in a company’s capital structure than equities, which provides further relative downside protection in a worst-case scenario (default). Long-term average recovery rates for high-yield bonds are north of 30 per cent. Equities, by definition, recover very little after restructuring or liquidation.
Investing in high-yield bonds, the emphasis is different. The focus is on the avoidance of downside risk, and this entails in-depth due diligence. While the high-yield manager will perform a great deal of cash flow modelling, the main focus should be on the sustainability of the investment’s capital structure. And while it is important to understand the potential upside of any investment, it should be understood that the vast majority of return in high yield comes from the coupon. If you can avoid the ‘blow-ups’ – instances where companies lurch towards default – this will stand you in good stead.